Economics

Consumers and Incentives

Dept. of Economics @ NCKU

Weng, Ming-Hung
 Question
How do you manage the time before the final
exams
 Water vs. Diamond

Why is water so necessary but so cheap,

while diamond so expensive but not essential
to life at all?
Outline

Buying among several alternatives

Optimal consumption choice
Demand
Income and substitution effect
 Question

Why does a soda machine only dispense one bottle or

can at a time, but a newspaper vending machine opens
up so that you could take as many as you want?
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 Marginal benefit
Marginal benefit (utility) is the additional
benefit (utility) derived from the consumption
of one more unit alone

Decreasing Marginal Benefit refers to

commonly observed lower MB from additional
unit when more units are consumed
5.1 The Buyers Problem

Buyers Problem:

1. What do you like?

2. How much does it
cost?
3. How much money
do you have?

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5.1 The Buyers Problem
What You Like: Tastes and Preferences

What do you like?

Everyone has different likes and dislikes, but we

assume everyone has two things in common:

1. We all want the biggest bang for our buck

(seeking the optimal choice)
2. What we actually buy reflects our tastes and
preferences (which is stable and known)
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5.1 The Buyers Problem
Prices of Goods and Services

How much does it cost?

: environment the buyers facing

We also assume two characteristics of prices:

1. Prices are fixedno negotiation

2. Not fear of driving the price up when buying
Consumers are price-takers
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5.1 The Buyers Problem
How Much Money You Have to Spend: The Budget Set

How much money do you have?

There are lots of things to do with your money, but

we assume:

1. There is no saving or borrowing, only buying

2. That even though we use a straight line to
represent purchase choices, we only purchase
whole units
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 Budget Set
Budget Set contains all
the affordable
consumption bundles at
given market prices
and under specific
income level
( , ) so that +

Budget Set

Budget constraint (line)

Budget set: the collection
of all affordable bundles
 What can a buyer do?
You have $300 USD to spend on jeans ( =
$50) and sweaters ( = $25).
Which consumption bundle ( , ) is
affordable? so that 50 + 25 300
1. (8, 0)
2. (4, 5)
3. (3, 6)
4. (2, 10)
Budget line

Why does the

budget line have
a negative slope?
Budget line
The slope of budget

line, =
5025 = 2 ,
represents the cost of
jeans in terms of
sweaters on market.
To increase each pair of
jeans, one has to give
up 2 sweaters, their
opportunity cost.
Budget line
The slope of budget line
is -1/2. It means
1. Each pair of jeans is
worth 1/2 unit of a
sweater
2. The cost of each
sweater is 1/2 pair of
jeans
Consumption choice(*)

Where would a
consumer choose?
1. Within budget
line
2. On budget line
3. Beyond budget
line
Budget Set(*)

What is your
optimal choice?
1. A;
2. B;
3. C;
4. D
5.2 Putting It All Together preference

Exhibit 5.2 Your Buyers Problem ($300 available)

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 Total Analysis

654.5

830
815

530
 Every hour counts!!
One hour left before the exams. If it is spent
on math, final grades can go up by 5 points
( ), and 10 points ( ) if it is on
economics. Should you spend this hour on
math or economics if you can only spend on
either one and you care only the sum of the
two grades.
1. Math
2. Economics
 Marginal Analysis (*)
Last 10 hours before the final, the table shows
the marginal grade each additional hour can
bring. Is to spend 5 hours on math and 5
hours on economics respectively optimal if
you only care the sum of the two grades?
1. Yes
3rd 4th 5th 6th 7th 8th
2. No
25 22 20 15 11 4
18 15 12 10 8 6
 Marginal Analysis
Last 5 hours before the final. The table shows the
marginal grade each additional hour can bring. If you
only care the sum of the two grades, while m hours
on math and e hours on economics respectively is
optimal arrangement of time. Then (m, e)=
1. (0, 5)
2. (5, 0) 1st 2nd 3rd 4th 5th
3. (4, 1)
4. (2, 3) 32 26 20 14 8
5. (3, 2) 25 19 13 7 1

 Every dollar counts!! (*)

If all income is spent and 5 = > = 4,

the consumer can benefit by
1. Exchange sweaters () for jeans ()
2. Exchange jeans for sweaters
3. No means
5.2 Putting It All Together preference

Exhibit 5.2 Your Buyers Problem ($300 available)

2015 Pearson Education, Ltd.

Marginal (bi-directional) Analysis

1.6 = < =3

2.6 = > = 1.6

Marginal Analysis

> difference shrinks when

exchanging sweaters for jeans

=


< difference shrinks when

exchanging jeans for sweaters
 Optimal consumption

If all income is spent and 2 = = = 2,

it is where the consumer is optimal; every
buck yields the same marginal benefit
with diminishing marginal benefit from
consumption,
the consumer will be worse off from exchanging
either commodity for the other because per dollar
benefit from more consumption will be less than 2.
 Every dollar is worth it!!
Optimal condition is when

= ; dollar spent on each commodity

yields the same benefit
Or

= ; subjective price of jeans equals

objective price (in terms of sweaters)
5.2 Putting It All Together

*Do you believe youre doing similar

calculation while shopping?
1. Yes
2. No 2015 Pearson Education, Ltd.
What about these activities?
 Comparative statics
Which graph reflects an increase in the price of
jeans? 1. A; 2. B; 3. C; 4. none of them
Comparative statics
If the price of jeans goes up
by 50%, will the quantity
demanded for jeans go up
or down?
 Comparative statics
Two impacts from increase in
1. Twist in budget line;
2. You blow your budgets

Two corresponding adjustment on jeans

1. Substitution effect : exchange jeans for sweaters as

= no longer holds (not optimal anymore)

2. Income effect : buy fewer jeans (if normal goods)
Substitution effect (*)
goes up by 50%.
How will you respond if you can
still buy the original bundle,
1. More jeans, fewer sweaters
2. Fewer jeans, more sweater

=

Substitution effect (*)
Substitution effect prescribes
a reduction in jeans (the
products whose price just
hiked) along with an increase
in sweaters consumption in
yielding a new optimality

=

income effect (*)

If the income drops, and

jeans are normal goods,
you will buy
1. More pairs of jeans
2. Fewer pairs of jeans
5.3 From the Buyers Problem to the Demand Curve
Sweaters $25 Jeans $50
Quantity Total Benefits Marginal Marginal Total Benefits Marginal Marginal Marginal
Benefits Benefits per Benefits Benefits per Benefits per
(A) Dollar Spent = (C) Dollar Spent = Dollar Spent =
(B) (B) / $25 (D) (D) / $50 (D) / $75

0 0 0
1 100 100 4 160 160 3.2 2.13
2 185 85 3.4 310 150 3 2
3 260 75 3 410 100 2 1.33
4 325 65 2.6 490 80 1.6 1.07
5 385 60 2.4 520 30 0.6 0.4
6 435 50 2 530 10 0.2 0.13
7 480 45 1.8 533 3 0.06 0.04
8 520 40 1.6 535 2 0.04 0.03
9 555 35 1.4 536 1 0.02 0.01
10 589 34 1.36 537 1 0.02 0.01
11 622 33 1.32 538
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1 0.02 -0.02
12 654.5 32.5 1.3 539 1 0.02 -0.07
Individual Demand

Exhibit 5.6 Your Demand Curve for Jeans

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5.3 From the Buyers Problem to the Demand Curve

Giffen good is inferior

goods with income
effect dominating
substitution effect

Substation ()+ Income effect () from price change

Exhibit 5.6 Your Demand Curve for Jeans

2015 Pearson Education, Ltd.

 question
Why do people end up spending more time on
highways (or modern transportation) when
they were supposed to bring easier
transportation?
 Conclusion
Consumption optimality requires each buck to
yield the same benefit
Substitution effect and income effects are how
economists describe the adjusting process
from the price impact